[BETA] Fortnightly

Understanding how the "normal purchase and sale exclusion" under FASB 133 affects earnings volatility.

You are a utility service provider. You don't normally have to hedge your energy purchases. You simply obtain a mix of long-term, medium-term, and spot physical purchases, and pass the costs on to your customer through your rate recovery mechanism-such as a fuel adjustment clause or a rate filing. Now, however, you are going to start serving customers who can purchase energy outside of the traditional rate recovery mechanism. These so-called "deregulated customers" are not going to accept pass-through of annual energy cost increases-although they may accept pass-through of energy cost decreases.

Funny how fickle a customer can be. But the problem of customer retention and satisfaction can be compounded for management when shareholders object to increased volatility of corporate earnings. Greater earnings volatility usually translates into lower price/earnings (P/E) ratios and lower P/Es equal lower share prices.

The P/E ratio is the price of a stock divided by its earnings per share. The P/E ratio, also known as a multiple, gives investors an idea of how much they are paying for a company's earnings power. The higher the P/E, the more investors are paying, and therefore the more earnings growth they are expecting.

The earnings volatility arises from the Financial Accounting Standards Board (FASB) Rule 133. Rule 133 mandates that energy contracts (purchases and sales) that are derivative contracts must be reported on the balance sheet as an asset or liability at fair value. Changes in fair value are recognized in earnings unless specific conditions are met.

If one enters into a supply contract that can be classified as a derivative, the change in value from one period to the next will be reflected in earnings. Consequently, a forward contract to purchase energy at an index price would be classified a derivative because the value of the contract will be uncertain until physical energy actually flows.

Fair value is determined by marking to market the value of the contract, e.g., the amount one would receive in cash if one sold the contract to a third party. The value is usually determined by reference to existing market data, also called a forward curve, published by a service provider (Platts, Bloomberg, Reuters, etc), the closing price of futures contracts traded on a commodity exchange (NYMEX, CBOT, etc.) or from broker quotations (APB Energy, PreBon, Amerex, etc.). In the case of an obligation to purchase, fair value would be reported as a liability, while the obligation to sell would be treated as an asset. If the fair value of the purchase changes from one accounting period to another, the change in fair value is reflected as an increase (fair value goes up) or a decrease (fair value does down) in earnings. For an example of this, see Figure 1.

The earnings volatility can be avoided by three different techniques.

Mark-to-Market Accounting Explained

Used by most large buyers and sellers of energy who are in the business of energy intermediation, mark-to-market accounting implicitly calculates fair value. Simply stated, it is the